Hedging: How to Hedge Using Futures Contracts

Hedging: How to Hedge Using Futures Contracts

In our last lesson we began a new course on the basics of futures trading with a look at how futures trading first began. In today’s lesson we are going to continue this discussion with a look at the primary purpose of the futures markets which is to give people the ability to hedge price risk.

This course is designed for the person who is seeking to profit from price fluctuations in the futures markets, who are also known as speculators. It is important for speculators to understand however, that like the primary purpose of the stock market is to help companies raise capital, the primary purpose of the futures markets is to help individuals and institutions hedge price risk. This is important for traders to understand, as an understanding of the motivations of the major players in a market is often helpful when analyzing that market.

So what is hedging and how exactly does it work in the futures markets? As we discussed in our last lesson, futures markets were originally invented to help smooth out wild fluctuations in the price of different agricultural products. The market did this by allowing both the farmer who sells agricultural products, and the companies that use those products in the goods they sell to consumers, the ability to hedge their price risk. To help better understand this lets look at an example of how this might work.

Lets say for example that there is a wheat farmer, who knows from past years that it costs him about $4.50 per bushel to plant and harvest his wheat crop. Before planting and harvesting the crop however there is no way for the farmer to know for sure what the price of wheat will be, putting him in a position where he could plant his crop, and potentially lose money should the price of wheat be at less than $4.50 come harvest time.

Continuing with this example, lets also say that there is a bread company who knows that they can sell their bread for $4.00 a loaf in the supermarkets, but if they price their bread much higher than this, their clients are not willing to pay for their bread. With this in mind, the company knows that if they can purchase wheat for $5 a bushel or less to make their bread with, then they can make a nice profit. If it costs them more than $5 a bushel for wheat, then they are going to have a problem making money selling their bread.

Next lets say that the farmer and bread producer in our example, just happen to know each other. By making an agreement whereby the bread producer agrees to buy the farmers wheat at harvest time at a price of $4.75 a bushel, regardless of what the prevailing price is at the time, both the farmer and the bread producer can remove the price uncertainty surrounding selling their products. The farmer is now assured of a $.25 profit per bushel on his wheat crop, and the bread producer has locked in a price for his wheat that allows him to make a nice profit selling his bread.

Now that we understand this, we can see how one of the primary purposes of the modern day futures market is to make this process of removing price risk or hedging easier, by standardizing the process, and creating one central place where buyers and sellers can come together. We should now also start to be able to see, how having an understanding of the motivations behind the hedgers in the market can be useful for those seeking to take on and try to profit from that price risk that hedgers are trying to avoid.

Thats our lesson for today. In our next lesson we will look at exactly how this process has been standardized in the modern day futures markets and the role that speculators seeking to profit from movements the price of different futures contracts play in the market so I hope to see you then. As always if there are any questions or comments please leave them in the comments section below, and good luck with your trading!

Links to Help You Learn More About Futures Hedging